Remember the old saying, “When it sounds too good to be true, it usually is?” My new client Stan came to the office the other day. Stan is the man looking for a plan!
Stan and his wife Ellen live in Mashpee, in a beautiful house right on the water on John’s Pond. They’re in their mid-60s. Stan’s had quite an exciting career. He first came to the Cape in his 20s as an airman at what was then Otis Air National Guard Base. One summer on the Cape was all Stan needed. He was hooked – that’s where he met Ellen, settled down and raised a family. Since then he’s worked in auto repair, newspaper publishing, and for the last 20 years, in healthcare management.
Stan and Ellen have worked hard and saved well over the years. With more of their local friends starting to head to warmer climates during the cold winters, they’re planning to do the same soon. Stan is looking forward to retiring in the near future and they want to make sure they have their ducks in a row. Stan and Ellen want predictable and reliable income as they move to the distribution phase of their financial lifecycle. Recently, they heard about an “investment strategy” that they thought was a pretty sure thing, and they were anxious to move $100,000 out of a newly matured CD into this new venture.
You see, the weekend before meeting with me, Stan and Ellen went to a cocktail party to celebrate the season with some of their friends. They met Al, a broker who works for a brokerage firm on the South Shore. Al told Stan about a way to generate a 7% annual distribution from a $100,000 investment. Seven thousand bucks of income sounded pretty good to them!
Hmmm . . . Stan was being asked to invest in a non-traded REIT.
So, I had to explain to him what a REIT is. Real Estate Investment Trusts (REITs) are securities that invest in real estate. Investors are promised dividends of rental income until the REIT sells its property and the REIT is liquidated. Upon liquidation, investors hope to receive more than what they initially invested; the idea is that the REIT’s property will have appreciated during the holding time. Many REITs are publicly traded on exchanges. You can buy and sell shares in them just like any other stock.
However, there’s another class of REIT, the non-traded REIT, and this was what Stan’s new broker friend was interested in selling him. As the name implies, non-traded REITs are not listed on exchanges. Unlike with publicly-traded REITs, there’s no secondary market for non-traded REITs. As a result, most non-traded REITs heavily limit the number of shares that can be redeemed before liquidation, too. Bottom line: Once you buy shares of a non-traded REIT, often times you’re stuck with them until the liquidation date, usually 7-10 years down the road.
The problem we have here is that the real estate market, just like the stock market, moves in cycles. An investor can own shares of a non-traded REIT that matures in a down market or that holds properties that are not sellable. And unfortunately, when that happens, there is little that can be done to protect the initial investment.
What’s more, most non-traded REITs start out as blind pools – money is raised for the non-traded REIT before it specifies which properties it will buy. That can make it difficult for a prudent investor to assess the actual risk associated with the REIT.
It’s also important to understand that if the rental income of a non-traded REIT is not enough to meet the promised distributions, often times, the non-traded REIT can borrow the necessary funds either from an institution or from other investors, to fund those distributions. That leverage can affect the value of the non-traded REIT’s shares. In fact, some can borrow more than 100 percent of net assets, and that can put non-traded REITs at a higher risk of defaulting or devaluation when it comes time to redeem or liquidate shares.
Brokers like Al often love non-traded REITs, because they can make a lot of money when selling them: 15% commissions aren’t unusual. And unfortunately, the fees, liquidity restrictions, and effects of leveraged capital are not always explained clearly to investors.
Fortunately, FINRA, the Financial Industry Regulatory Authority, made changes in 2016 to require issuers of non-traded REITs to be more transparent than they used to be in revealing those fees, commissions and share value.
That improved disclosure has caused the non-traded REIT market to shrink considerably. Non-traded REIT sales totaled $20 billion in 2013 but fell to $4.5 billion in 2016 and are predicted to be flat this year, too. In fact, the changing landscape of non-traded REITs caused W.P. Carey, the corporate real estate financing firm once considered the “gold standard” for non-traded REITs, to announce that it is exiting the market altogether.
Once I explained the ins and outs of non-traded REITs to Stan, he agreed that investing in one is not in his best interest. We spent some time together creating a retirement system with a combination of strategies that will provide the predictable guaranteed income Stan and Ellen are looking for and the potential for growth that will allow them to have their “fun in the sun.”
Stan is now the man with a plan.
Be vigilant and stay alert, because you deserve more.
Have a great week.
Jeff Cutter, CPA, PFS is President at Cutter Financial Group, LLC, with offices is Falmouth, Plymouth, and Mansfield. Cutter Financial Group provides private wealth and investment management advice incorporating low risk, low volatility financial strategies. Jeff can be reached at firstname.lastname@example.org.
Cutter Financial Group LLC (“Cutter Financial”) is a registered investment advisor.
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